Description

Of all the companies I own, Twin Disc (ticker TWIN) has the worst investor relations efforts and the most compelling valuation. Its 10k is confusing and non-descriptive, they release earning (which are great!) on Fridays after the market closes because management is very conservative, and they never “roadshow”. However, I believe this poor investor relations effort (which is about to improve dramatically), combined with the stock’s limited liquidity provide a very attractive opportunity for investors to buy this rapidly growing, leading market share niche manufacturer and distributor of heavy-duty off-highway power transmission equipment (transmissions, surface drives, propellers, clutches, etc). Its end markets are the marine, industrial, military, energy and agricultural markets which are all experiencing cyclical recoveries and TWIN believes it is also gaining share in these markets. TWIN trades at 0.5x LTM revenue, 5.0x LTM EBITDA, expects 10%ish organic revenue growth (excluding a recent acquisition of Rolla) and improving margins over the next year, pays a 2.7% dividend yield, has a very heathly balance sheet and has significant insider ownership (26%). A major catalyst (besides the very strong earnings the company will report in a few weeks) is that the company is now committed to upgrading its investor relations efforts and over the next few months will be making some dramatic changes which may include visiting potential investors, hosting earnings calls, providing more disclosure about its business, providing earnings guidance and a stock split to increase liquidity. Note that despite my earlier comments, management is more than glad to talk if you call them and the CFO is very user friendly.

TWIN manufactures products for 3 major business areas and has the #1 or #2 market share in most of the niche markets in which it competes. After several years of disappointing results, the company is benefiting from improved demand for its products as well as operational improvements (increased outsourcing of certain manufacturing, pension curtailment, headcount reduction) made in recent years. In the Sept 2004 Q, revenue was up 16% organically and 19% in total (the difference resulting from the May 2004 Rolla acquisition). The company’s products are machined from cast iron, forgings, cast aluminum and bar steel, so the company has some commodity exposure. However, despite rising raw material costs, the company has been able to increase gross margins y/y as a result of the operational improvements discussed above as well as the growing revenue base. Furthermore, management believes it can continue increasing its gross margin.


Below are some recent results that illustrate the turnaround occurring at the company. Note that Q1 is seasonally weak due to vacations in Europe so don’t compare Q1 results to full yr results. Also, in FY 2004 TWIN changed the accounting with a JV which reduced reported revenue by $13.7mm but not profits. So, I have shown reported FY 2004 and Adj. FY 2004 to show an apples to apples comparison. FY ends in June.


Rep adj Q ended sept 30,
FY 2003 FY 2004 FY 2004 2003 2004
revenue 179.6 186.0 199.7 38.0 45.4
gross profit 35.1 47.6 47.6 8.9 11.8
ebitda 6.0 16.1 16.1 2.0 3.5
ebit 0.3 10.4 10.4 0.5 2.3

rev growth NA 3.6% 11.2% NA 19.5%
gross margin 19.5% 25.6% 23.8% 23.4% 26.0%
EBITDA % 3.3% 8.7% 8.1% 5.2% 7.8%
EBIT % 0.2% 5.6% 5.2% 1.4% 5.0%





The Sept Q showed 19.5% or $7.4mm revenue growth y/y. The Rolla acquisition contributed $1.5mm of that growth, so organic growth was $5.9 or 15.6%. $2.4mm of this organic growth came from the first part of a contract to supply transmission systems to the Israeli Defense Forces. This contract is for $15mm over approximately 18 months, which means the company still has $13mm of revenue to book from this contract. This contract puts TWIN at a significant competitive advantage to win additional contracts with the Israeli military. The company has indicated it is bidding on several major contracts (not just with Israel) that would significantly increase revenue. However, currently the company does not have exposure to any single extremely large contract. Excluding the impact of the Israel contract, which is overly punitive since it assumes the company could not have sold the products elsewhere (especially since the company says it was unable to meet demand for many of its customers due to shortage of materials), organic growth would have been 9.2% last Q.

The company reports 2 segments, manufacturing and distribution. Manufacturing (70+% of rev) represents products that I will break down below. Distribution is company owned distributors (the largest ones being abroad, Singapore and Australia) , 95+% of whose revenue comes from the sale of TWIN products. A vast majority the Distribution revenue is from sale of Twin’s marine products. These distributors are profitable and TWIN views them as strategic part of its overall business.

The company does not divulge revenue by end market. They verbally provided me the following breakdown which is a breakdown of total revenue (manufacturing and distribution):

1) Marine Transport and Propulsion (approximately 50% of revenue): Manufactures transmissions, surface drives, water jets for pleasure craft, commercial and military boats.

2) Off-highway Vehicle Transmission Systems (approximately 25% of revenue): Manufactures transmissions, torque converters and electronic controls for military, agricultural, and all-terrain specialty vehicles.

3) Industrial Products (approximately 25% of revenue) Sells industrial products such as power take-offs, clutches and control systemes to the agricutltural, environmental and energy markets.


For more info on TWIN’s products go to its website http://www.twindisc.com/



Balance Sheet
The company has a very healthy balance sheet, with net debt/ebitda of 1.0x. It is unlikely the company will return capital to shareholders either via a special dividend (stock currently yields 3%) or stock buyback (the float is already small). Management wants to “keep its powder dry” for additional acquisitions like Rolla (that has performed very well). However, I also would not be surprised if the company went private at some point as management is beginning to realize the costs (financial and otherwise) of such a microcap company to remain public in today’s markets. If we add back $1.5mm of annual public company expenses, TWIN would be trading at 4.7x LTM EBITDA. But, a possible LBO is not why we bought the stock.

Capex
The company’s recent capex has been obscured by 2 factors. #1 is the May 2004 $5.1mm acquisition of Stella broken out in the 10k cf statement. #2 is an incremental $4mm the company has spent since the acquisition through the not yet released Dec 10Q to build a larger, state of the art manufacturing facility for Stella to allow for the additional growth the company expects. Going forward, maintenance capex (excluding any acquisitions) should equal depreciation of approximately $5mm.

Acquisitions
The company would like to grow through acquisitions. However, management is quite conservative and selective about acquisitions. Since they personally own 27% of the company, I do not anticipate they will make any crazy investments. TWIN does however realize that a good acquisition could be highly accretive as it might 1) offer operating synergies with TWIN’s current operations and distribution channels; 2) spread higher revenues over the fixed component of its cost structure; 3) increase earnings by leveraging the balance sheet a bit and 4) increasing the size of the company and thus attracting a new set of investors. Note that management does not want to issue stock for its acquisitions, which is why the balance sheet remains so overcapitalized. Acquisitions will likely be in the industrial segment as they offer the highest number of acquisition candidates as well as the highest potential synergies.

Pension
At June 2004, the company’s pension was underfunded by $35.1mm, but in the Sept Q they funded $4.3mm of an expected $7.5mm FY2005 cash contribution. In the 10k you will also see a $30mm underfunded Other Benefits Plan, but the company does not have to fund this pay as you go plan.

People treat the pension underfunding in different ways. I believe most people simply ignore it (look at an auto or airline stock recently?), but since I don’t want to get into a discussion about how to value pensions, I will provide some additional information and let you decide how to treat it.

My Est. Pension Underfunding at 9/30/04: $30.8 = 35.1 - 4.3
LTM pension expense that hit P/L= net periodic benefit cost= $6.0 = 1.1-1.6+6.5 (note that pension expense this FY will be about $2mm less than previous FY)

We looked at the pension impact in 2 ways:

1) straight EV calculation: ignoring pension for EV calculation and using reported EBITDA which obviously has pension expense.


$73mm Equity mkt cap - 8 cash + 25.3 debt = 90EV divided by 17.7
mm ltm ebitda

this yields a 5.0x ev/ltm ebitda



2) Adjusted EV calculation: adding back current underfunding to EV and adding back pension expense to EBITDA

$90mm EV+ 30.8 underfunding = 121.7 adj. ev
17.7mm ebitda + 6.0 ltm pension expense = 23.7mm adj ebitda

this yields a 5.1x adj ev/adj ltm ebitda



Management
Michael Joyce, the company’s President and CEO is 64. I believe Mr. Joyce had planed to resign in the next year or so, but has since changed his mind (I do not know why, but I believe his minor stock sales were because of his plan at that time to step down in the near future). Michael Batten, Chairman and CEO, 65 years old, is extremely active in the company, owns 23% of the stock, plans to continue working for as long as he possibly can. Mr. Batten’s son John, 40 years old, does have a sr management role. While we generally avoid companies with 2nd generation family managers, our diligence on John (Yale undergrad, engineering degree from U. of Colorado, Harvard Management Program) lead us to believe he is a capable manager. Furthermore, management compensation is very reasonable so this is not a case where a family is “raping” a public company. Chris Eperjesy, 37, is the CFO and is very knowledgeable and user friendly.


LIFO Reserve
The company also has a $20mm LIFO reserve, which makes the company even cheaper on book value, but if you don’t already think its dirt cheap, the LIFO reserve isn’t gonna convince you.


TWIN is an undiscovered, rapidly growing, undervalued company run by a strong management team with significant insider ownership. Although the stock is somewhat illiquid there appears to be some stock available on the open market. We believe there is so much upside in the stock that we have been and continue to be willing to “pay up” despite the big bid/ask spreads. This approach has worked well for us in other similar situations that we have written up here (GOT, HGGR, HWK,NSH) where we got aggressive before the market woke up to the stock’s intrinsic value.

Catalyst

Strong earnings released later this month
New investor relations efforts
New significant contract awards
Potential accretive acquisitions